Time-Varying Incentives in the Mutual Fund Industry Jacques Olivier HEC Paris Anthony Tay Singapore Management University

Time-Varying Incentives in the Time-Varying Incentives in the Mutual Fund IndustryMutual Fund Industry

Jacques OlivierJacques OlivierHEC ParisHEC Paris

Anthony TayAnthony TaySingapore Management UniversitySingapore Management University

MotivationMotivation Existing empirical literature on mutual fund flows:Existing empirical literature on mutual fund flows:

Ippolito (1992), Ippolito (1992), Gruber (1996), Chevalier and Ellison (1997), Sirri Gruber (1996), Chevalier and Ellison (1997), Sirri and Tufano (1998), Del Guercio and Tkac (2002), Lynch and and Tufano (1998), Del Guercio and Tkac (2002), Lynch and Musto (2003), Barber, Odean and Zheng (2005), Gallaher, Kaniel Musto (2003), Barber, Odean and Zheng (2005), Gallaher, Kaniel and Starks (2006) and Huang, Wei and Yan (2007)…and Starks (2006) and Huang, Wei and Yan (2007)…

Because of fee structure, investor flows shape the Because of fee structure, investor flows shape the incentives of mutual fund managersincentives of mutual fund managers

Crucial property of flows: convex function of past Crucial property of flows: convex function of past performance, which provides incentives for strategic performance, which provides incentives for strategic risk-shiftingrisk-shifting

Chevalier and Ellison (1997), Brown et al. (1996)Chevalier and Ellison (1997), Brown et al. (1996)

Preview (1)Preview (1)

Central result of this paper:Central result of this paper: Convexity of the flow-performance relationship Convexity of the flow-performance relationship

varies with economic activityvaries with economic activity

The stronger is economic activity, the more The stronger is economic activity, the more convex is the flow-performance relationshipconvex is the flow-performance relationship

Preview (2)Preview (2) 5 issues:5 issues:

(i) Is the effect economically significant?(i) Is the effect economically significant?• YES: YES:

+1% GDP growth implies (more than) twice as much +1% GDP growth implies (more than) twice as much convexity as on averageconvexity as on average-1% GDP growth implies no convexity whatsoever (and even -1% GDP growth implies no convexity whatsoever (and even some concavity)some concavity)

(ii) Is the effect driven by “abnormal” years?(ii) Is the effect driven by “abnormal” years?• NO: removing years with deep recessions or strong booms NO: removing years with deep recessions or strong booms

leaves the result unchangedleaves the result unchanged

Preview (3)Preview (3) 5 issues (continued):5 issues (continued):

(iii) Through which channel does economic activity affect (iii) Through which channel does economic activity affect the nature of the flow-performance relationship?the nature of the flow-performance relationship?

• GDP growth, NOT market returnsGDP growth, NOT market returns• Aggregate flows, NOT volatilityAggregate flows, NOT volatility• Consistent with consumption smoothing + disposition effectConsistent with consumption smoothing + disposition effect

(iv) Does the time variation of the flow-performance (iv) Does the time variation of the flow-performance relationship affect decisions of fund managers?relationship affect decisions of fund managers?

• YES: strategic risk-shifting occurs only when GDP growth is highYES: strategic risk-shifting occurs only when GDP growth is high• Effect of GDP growth dominates that of market returnsEffect of GDP growth dominates that of market returns

Preview (4)Preview (4) 5 issues (continued):5 issues (continued):

(v) Other reasons why we care about the result:(v) Other reasons why we care about the result:• Rationalizes existing results on mutual fund performance Rationalizes existing results on mutual fund performance

over the business cycleover the business cycle• Methodological aspectsMethodological aspects• Time-varying risk premia (more tentative…)Time-varying risk premia (more tentative…)

Data and Methodology (1)Data and Methodology (1) No-load US domestic equity mutual funds appearing in CRSP No-load US domestic equity mutual funds appearing in CRSP

survival bias free mutual fund database between 1980 and 2006survival bias free mutual fund database between 1980 and 2006

Exclude multiple classes, index funds, funds of funds, funds closed Exclude multiple classes, index funds, funds of funds, funds closed to investors, funds that never reached 10M$ of total net assetsto investors, funds that never reached 10M$ of total net assets

Flow variableFlow variablei,ti,t = Dollar Flow = Dollar Flowi,ti,t = TNA = TNAi,ti,t – (1+r – (1+ri, ti, t) TNA) TNAi,i, t-1t-1 Where TNAWhere TNAi,ti,t represent Total Net Assets at the end of year t represent Total Net Assets at the end of year t

Data and Methodology (2)Data and Methodology (2) Rank (or relative performance): year-by-year ranking of Rank (or relative performance): year-by-year ranking of

fund managers according to their (1-factor) alpha:fund managers according to their (1-factor) alpha:• Measure between 0 (worse performer) and 1 (best performer)Measure between 0 (worse performer) and 1 (best performer)

Following Sirri and Tufano (1998), divide performance in Following Sirri and Tufano (1998), divide performance in three regions:three regions:

TOP: top quintile (relative performance from 0.8 to 1)TOP: top quintile (relative performance from 0.8 to 1) MIDDLE: middle three quintiles (from 0.2 to 0.8)MIDDLE: middle three quintiles (from 0.2 to 0.8) BOTTOM: bottom quintile (below 0.2)BOTTOM: bottom quintile (below 0.2)

Estimate piecewise linear regression of current flows on Estimate piecewise linear regression of current flows on past performancepast performance

Robustness checks: Robustness checks: Rank managers by their excess returns or by their 4-factor alphasRank managers by their excess returns or by their 4-factor alphas Use 1-factor alphas themselves instead of the rankingUse 1-factor alphas themselves instead of the ranking

Data and Methodology (3)Data and Methodology (3) Standard flow-performance regression (e.g. Sirri and Tufano, 1998):Standard flow-performance regression (e.g. Sirri and Tufano, 1998):

Where:Where:

Data and Methodology (4)Data and Methodology (4)

Interpretation of the standard regression:Interpretation of the standard regression: There is convexity if and only aThere is convexity if and only a11 – a – a33 is positive and is positive and

significantsignificant

In other words, if and only if flows react more to In other words, if and only if flows react more to differences in performance of good performers than differences in performance of good performers than to differences in performances of lousy performersto differences in performances of lousy performers


What we test in this paper: What we test in this paper: Does the difference aDoes the difference a11 – a – a33 vary with economic activity? vary with economic activity?

Our basic regression:Our basic regression:


Interpretation: Business cycle effects measured by Interpretation: Business cycle effects measured by deviations (in percentage) of real US GDP growth deviations (in percentage) of real US GDP growth from its sample meanfrom its sample mean Year-fixed effects: take care of impact of business cycle Year-fixed effects: take care of impact of business cycle

on the intercepton the intercept

Slope effects: captured by interaction variable:Slope effects: captured by interaction variable:

Data and Methodology (7)Data and Methodology (7) Interpretation of coefficient on performance: impact of Interpretation of coefficient on performance: impact of

performance on flows performance on flows when US GDP growth is equal to when US GDP growth is equal to its sample meanits sample mean

Interpretation of coefficient on interaction variable: how Interpretation of coefficient on interaction variable: how does a +1% deviation of GDP growth change the (total) does a +1% deviation of GDP growth change the (total) impact of performance on growthimpact of performance on growth


Tests of convexityTests of convexity Flow-performance relationship is convex on average if Flow-performance relationship is convex on average if

and only if:and only if:

aa11 is (significantly) larger than a is (significantly) larger than a33

A +1% increase of GDP growth rate increases convexity A +1% increase of GDP growth rate increases convexity if and only if:if and only if:

aa44 is (significantly) larger than a is (significantly) larger than a66

Data and Methodology (9)Data and Methodology (9) Unbalanced Panel DataUnbalanced Panel Data

Year fixed effects though year dummy variablesYear fixed effects though year dummy variables Standard errors clustered by fundsStandard errors clustered by funds

Methodological remark: Methodological remark: Usual methodology used in mutual fund flows literature: Fama-Usual methodology used in mutual fund flows literature: Fama-

Mac Beth regressionsMac Beth regressions Assumes that slope coefficients in each annual regression drawn Assumes that slope coefficients in each annual regression drawn

from the same distributionfrom the same distribution Not valid if systematic time variation at business cycle frequency Not valid if systematic time variation at business cycle frequency

in slope coefficientsin slope coefficients Comparable to point made 10 years ago in the asset pricing Comparable to point made 10 years ago in the asset pricing

literature (conditional vs. unconditional CAPM)literature (conditional vs. unconditional CAPM)

Basic Results (1)Basic Results (1)



Interpretation:Interpretation: Flow-performance relationship convex on average Flow-performance relationship convex on average

Stronger reaction of flows to good performance when economic Stronger reaction of flows to good performance when economic activity is strongactivity is strong

Stronger convexity of the flow-performance relationship when Stronger convexity of the flow-performance relationship when economic activity is strongeconomic activity is strong

Order of magnitude: a +/- 1% change of GDP growth (more than) Order of magnitude: a +/- 1% change of GDP growth (more than) doubles / eliminates the convexity in the flow-performance doubles / eliminates the convexity in the flow-performance relationshiprelationship

Robustness ChecksRobustness Checks

Economic Interpretation (1)Economic Interpretation (1)


Candidate 1: flow composition effectCandidate 1: flow composition effect Step 1: convexity of new inflows and of portfolio rebalancing flowsStep 1: convexity of new inflows and of portfolio rebalancing flows

• Investors look for positive alpha fundsInvestors look for positive alpha funds

• Positive alpha funds concentrated in upper tail of the distributionPositive alpha funds concentrated in upper tail of the distribution

Step 2: outflows are a flat or concave function of performanceStep 2: outflows are a flat or concave function of performance• Concentration of portfolios + short-sale constraintsConcentration of portfolios + short-sale constraints

• Disposition effectDisposition effect

Step 3: more outflows when economic activity is weakStep 3: more outflows when economic activity is weak• Consumption smoothingConsumption smoothing


Candidate 2: volatility effectCandidate 2: volatility effect Step 1: convexity driven by investors looking for positive alpha Step 1: convexity driven by investors looking for positive alpha

fundsfunds

Step 2: volatility is countercyclicalStep 2: volatility is countercyclical

Step 3: performance is less informative about skill when volatility Step 3: performance is less informative about skill when volatility is high (more noise)is high (more noise)


Implications (1)Implications (1)

Tournament HypothesisTournament Hypothesis Brown et al. (1996), Chevalier and Ellison (1997): convexity of flow-Brown et al. (1996), Chevalier and Ellison (1997): convexity of flow-

performance relationship provides incentives for poor mid-year performance relationship provides incentives for poor mid-year performers to take on more riskperformers to take on more risk

Empirical evidence on risk-shifting: very mixed depending on Empirical evidence on risk-shifting: very mixed depending on samplessamples

Kempf et al. (2008): cost of switching jobs imply more risk-shifting Kempf et al. (2008): cost of switching jobs imply more risk-shifting under good than under bad market conditionsunder good than under bad market conditions

2 issues:2 issues:• No direct estimate of cost of switching jobs and relative magnitude No direct estimate of cost of switching jobs and relative magnitude

compared to high-powered incentives in the industrycompared to high-powered incentives in the industry• Could go either way (foregone bonuses)Could go either way (foregone bonuses)


Conditional Tournament HypothesisConditional Tournament Hypothesis When the flow-performance relationship is convex, then poor mid-When the flow-performance relationship is convex, then poor mid-

year performers have incentives to increase the risk of their year performers have incentives to increase the risk of their portfoliosportfolios

Thus, more risk-shifting when economic activity is strongThus, more risk-shifting when economic activity is strong

If risk-shifting mostly driven by the flow-performance relationship If risk-shifting mostly driven by the flow-performance relationship then no impact of market conditions on risk-shifting once then no impact of market conditions on risk-shifting once business cycle effects are accounted forbusiness cycle effects are accounted for


Conditional Tournament Hypothesis (continued)Conditional Tournament Hypothesis (continued)

Negative coefficient of interaction variable: poor performers Negative coefficient of interaction variable: poor performers increase their risk even more when GDP growth is highincrease their risk even more when GDP growth is high

Year fixed effect and fund clustered standard errorsYear fixed effect and fund clustered standard errors



Conclusion:Conclusion: Behavior of fund managers is consistent with time-series Behavior of fund managers is consistent with time-series

properties of the flow-performance relationshipproperties of the flow-performance relationship

Reconciles insights of seminal papers in the field with conflicting Reconciles insights of seminal papers in the field with conflicting empirical evidenceempirical evidence

Once time-varying nature of incentives are accounted for, only mild Once time-varying nature of incentives are accounted for, only mild support for impact of employment risksupport for impact of employment risk

Some evidence in favor of market timing by fund managers Some evidence in favor of market timing by fund managers

Other Reasons to Care About the ResultOther Reasons to Care About the Result

Kosowski (2006): Funds have significantly larger alphas Kosowski (2006): Funds have significantly larger alphas during recessions than during boomsduring recessions than during booms

This paper provides a possible rationale for the result: more This paper provides a possible rationale for the result: more distortion of incentives of mutual fund managers during boomsdistortion of incentives of mutual fund managers during booms

Mechanism supported by Huang et al. (2008): risk-shifting destroys Mechanism supported by Huang et al. (2008): risk-shifting destroys valuevalue

Asset pricing literature: Non constant discount factorsAsset pricing literature: Non constant discount factors This paper provides a (very) specific example where business cycle This paper provides a (very) specific example where business cycle

variations generate endogenously shifts to risk aversion of agents variations generate endogenously shifts to risk aversion of agents (fund managers)(fund managers)

Documents

Time-Varying Incentives in the Mutual Fund Industry Jacques Olivier HEC Paris Anthony Tay Singapore Management University